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Successor Liability When Buying A Business

Successor Liability When Buying A BusinessA major concern of anyone buying a business should be whether or not they will be exposed to any of the seller's liabilities.  Successor liability (i.e., a buyer being held liable for a seller's obligations) exists in the following situations:

1. Stock Purchase instead of an Asset Purchase.  If a buyer purchases a business by acquiring the common stock of a corporation, the partnership interests in a partnership, or the membership interests in a limited liability company, the buyer steps into the shoes of the seller as the owner of the entity.  The entity continues to own its business assets, and the entity continues to be responsible for its obligations and liabilities.

A seller of such an ownership interest is obligated to disclose the entity's known liabilities to a buyer, but another major concern to a buyer should be the "contingent" liabilities of that entity.  Contingent liabilities are those liabilities that have been incurred by the entity prior to the ownership interest being acquired by the buyer, but the seller is unaware of them.  Contingent liabilities may or may not turn into actual obligations.  For example, a customer that slips and falls in a store before an acquisition might or might not file a lawsuit against the entity for their injuries.

In general (see exceptions below), a buyer can avoid these contingent liabilities by structuring the purchase transaction as an asset purchase.  In an asset purchase, the buyer acquires the business assets, but not the business liabilities.

2. Public Policy Exception for Manufacturing Businesses (the "Product Line Successor" rule)

Although structuring the business purchase transaction as an asset acquisition will normally protect a buyer from a seller's contingent liabilities, California's Supreme Court has created an exception that applies under certain limited circumstances for manufacturing businesses.

Thus, even when a buyer acquires just the assets of a manufacturing business, courts have imposed liability where all of the following apply: (1) the plaintiff's remedies against the original manufacturer have been destroyed as the result of the successor's acquisition of the business; (2) the successor has the ability to assume the original manufacturer's risk-spreading role; and (3) it is deemed to be fair to require the successor to assume a responsibility for defective products because it was a burden necessarily attached to the original manufacturer's goodwill that is being enjoyed by the successor in the continued operation of the business.

The best protection for a buyer against this type of liability would be to obtain insurance that provides coverage against this sort of claim.  Such insurance could be either obtained by the buyer to cover liabilities arising prior to the acquisition or by requiring the seller to carry insurance against this sort of claim for a reasonable period after the acquisition.

3. Failure to Comply with Bulk Sale Laws

In an asset sale, successor liability for the seller's trade credit may also exist where a buyer acquires more than one-half of the seller's inventory and equipment.  The buyer can obtain protection from such liability by complying with California's bulk sale laws.  These laws protect trade creditors by imposing liability on the buyer, unless the buyer provides appropriate notice of the bulk sale.  The notice must contain specific information, and it must be recorded, published and provided to the county tax collector.

Bulk sales law also provides a mechanism for creditors making claims on the purchase money consideration.  These laws do not apply to all businesses, but they do apply to businesses that purchase and sell inventory.  Because of the complexity of complying with the bulk sales laws, buyers should open a bulk sale escrow with a reputable escrow company to ensure that bulk sale procedures are followed.

4. Taxes

While a buyer is not obligated to pay the seller's income taxes when the transaction is structured as an asset sale, successor liability may exist for California Sales and Use Tax, taxes payable to the California Employment Development Department, and taxes required to be withheld by the California Franchise Tax Board.

A buyer is required to withhold a sufficient portion of the purchase price to cover the seller's liability for California Sales and Use Tax until the seller produces a receipt from the Board of Equalization showing full payment or a certificate indicting that no amount is due.  This liability includes both taxes due from the sale of the assets to the buyer and taxes from prior sales made by the seller.

A buyer is also required to withhold a sufficient amount to cover the seller's due or unpaid contributions to the California unemployment fund, employment training fund, and unemployment compensation disability fund until the seller produces evidence from the Employment Development Department that no such payments are due.

A similar withholding requirement exists for the seller's taxes required to be withheld under California's franchise and income tax laws, and buyers should obtain a release from the Franchise Tax Board to avoid liability for these taxes.

To avoid being saddled with the seller's tax liability and related penalties, a buyer would be wise to acquire the business through a business escrow service.  The escrow officer will either obtain the necessary releases from the taxing authorities prior to closing escrow or withhold enough of the purchase price from the seller to pay these taxes if any are due.

Joe SandbankAbout The Author:  Joe Sandbank is an attorney specializing in assisting business buyers, business owner/sellers, business brokers, and agents with legal matters pertaining to buying and selling businesses throughout California. Joe can be reached direct at 800-875-1480.

Categories: BizBen Blog Contributor, Buying A Business, How To Buy A Business, Legal Topics

Comments Regarding This Blog Post

Joe's advice is excellent, but I'll add one simple but very important point. While I am a business broker in California, I am also a licensed attorney in New Jersey where I practiced for many years before seeing the light and "moving west to the best." But, as an attorney, I advised many clients on the purchase of a business. And, while it is crucial to have a professional seasoned escrow officer handle the transaction, as Joe said, it is equally and critically important to be represented by an attorney experienced specifically in business transaction law. Over the years I have seen huge insurmountable costly problems that could have been prevented easily by the early and full involvement of a competent lawyer in the process.

  Helpful Resources To Assist In Selling And Buying California Businesses
Diane Boudreau-Tschetter: Escrow And Bulk Sale Services

California Business Escrow, Inc. is a full service independent escrow company serving all of California and has expertise in a wide range of escrows. Our team prides itself on providing an exceptional escrow experience. For more info phone Diane Boudreau-Tschetter at 888-383-3331 or 209-838-1100.

Elizabeth McGovern: Escrow Services - SF Bay Area

McGovern Escrow Services, Inc., is a leading independent escrow company. We are a trusted partner with our clients, assisting them through the tangled bulk sale & liquor license transfer process. We provide attentive, quality & innovative customer service. Phone Elizabeth McGovern at 415-735-3645.

Helen Yoo: Escrow & Bulk Sale Services - Southern California

New Century Escrow, Inc. is a fully licensed & bonded independent escrow company. Over 20 years combined experience in handling bulk escrow transactions. Multi-lingual staff that speaks your language, including Korean, Chinese, Vietnamese. Call Helen Yoo direct at 626-890-1151.

Shalonda Chappel-Pilgram: Escrow Services - Southern CA

Escrow services to brokers & agents, owner/sellers, & buyers. Established 43 years. Extraordinary service. Experienced with handling difficult transactions. One stop for all your escrow needs: Bulk sales, lien searches, UCC searches, liquor license transfers, publishing & recording services.

Janet Carrera - Escrow & Bulk Sale Services - SF Bay Area

Redwood Escrow Services, Inc. is a full service, licensed independent escrow company. We are EAFC Fidelity bonded, fully insured & licensed with the Department of Corporations. Committed to offering our clients the most comprehensive variety of escrow services available. Phone Janet at 510-247-0741.

Brad Steinberg, Broker - Laundromat Specialists

PWS is the leading laundromat broker in California. Since 1968 PWS has brokered over 2,500 laundromat sales. With over 90 employees dedicated to the coin laundry industry, PWS has 18 licensed agents, a 3 person in-house finance department, 10 service technicians and a 20 person parts department.

Willard Michlin, CPA, Certified Fraud Examiner, Due Diligence Services

Willard Michlin, CPA #106752, offers buyers step by step training & assistance in doing Due Diligence Services when they are thinking of making an offer, or are in process of investigating a business purchase. He helps to determine the actual net profit even when there is cash. Call 805-428-2063.

Joe Sandbank, Esq. - Legal Services

I have provided legal counsel to business buyers, sellers and brokers for over 17 years. With prior experience as a business broker and SBA loan officer, Joe brings both a practical and legal approach to all aspects of the business acquisition process.

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